Liquidity, taxes and yield spreads between tax-exempt and taxable bonds
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This paper proposes a dynamic pricing model for municipal bonds with the liquidity factor and time-varying risk premiums. I estimate the parameters of the model using the Kalman filter. I find that the estimate of the marginal investor’s income tax rate from the generalized model is very close to the statutory corporate tax rate over the periods with different tax regimes. Ignoring the liquidity risk premium which is an important component of municipal yields, and failing to use the estimation method that efficiently captures time-varying features of risk premiums result in biased estimation of marginal investor’s implicit tax rates.